Interest Rates and Bond Valuation 1

Bond Features and Prices A bond is normally an interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan. For example, suppose the TBA Corporation wants to borrow $1,000 for 30 years. The interest rate on similar debt issued by similar corporations is 12 percent. TBA will thus pay 0.12 x $1,000 = $120 in interest every year for 30 years. At the end of 30 years, TBA will repay the $1,000. 2

To determine the value of a bond at a particular point in time, we need to know the number of periods remaining until maturity, the face value, the coupon, an the market interest rate for bonds with similar features. This interest rate required in the market on a bond is called the bond’s yield to maturity (YTM). For example, suppose the Xanth Co. were to issue a bond with 10 years to maturity. The Xanth bond has an annual coupon of $80. Similar bonds have a yield to maturity of 8 percent. Based on our discussion above, the Xanth bond will pay $80 per year for the next 10 years in coupon interest. In 10 years, Xanth will pay $1,000 to the owner of the bond. Bond Values and Yields 3

Bond Values and Yields (cont.) 4 We thus estimate the market value of the bond by calculating the present value of these two components separately and adding the results together. First, at the going rate of 8 percent, the present value of the $1,000 paid in 10 years is : Present value = $1,000/ = $ Second, the bond offers $80 per year for 10 years, so the present value of this annuity stream is : Annuity present value = $80 x (1-1/ )/.08 = $536.81

Bond Values and Yields (cont.) 5 We can now add the values for the two parts together to get the bond’s value: Total bond value = $ $ = $1,000 The following general equation can be solved to find the value of any bond: Bond Value = C x [ 1 – 1 / (1 + r) t ] / r + F / (1 + r) t

Discount Bond 6 Suppose a year has gone by. The Xanth bond now has nine years to maturity. If the interest rate in the market had risen to 10 percent, what would the bond be worth? Bond value = $80 x (1-1/ )/ $1,000/ = $ Since this bond pays less than the going rate, investors are only willing to lend something less than the $1,000 promised repayment. Since the bond sells for less than face value, it is said to be a discount bond.

Premium Bond 7 What would the Xanth bond sell for if interest rates had dropped by 2 percent instead of rising by 2 percent? The Xanth bond now has a coupon rate of 8 percent when the market rate is only 6 percent. Investors are willing to pay a premium to get this extra coupon. In this case, the relevant discount rate is 6 percent, and there are nine years remaining. The bond value is thus, Bond value = $80 x (1-1/ )/ $1,000/ = $1, As you might guess, the bond will sell for more than $1,000. Such a bond is said to sell at a premium and is called a premium bond.

8 Finding the Yield to Maturity Frequently, we will know a bond’s price, coupon rate, and maturity date, but not its yield to maturity. For example, suppose we were interested in a six-year, 8 percent coupon bond. A broker quotes a price of $ What is the yield on this bond? With an $80 coupon for six years and a $1,000 face value, this price is: $ = $80 x [1 – 1/(1+ r) 6 ]/ r + $1,000/ (1+r) 6 In this case, by trying Trial-and-Error method you would probably find out, almost 9 percent is the bond’s yield to maturity. Or we use its formula, [ C + ( F – P ) / t ] [ 80 + ( )/6] YTM = = = 8.95% ( F + P ) / 2 ( )/2

Finding the Yield to Maturity (cont.) 9 Example Bond Yields You’re looking at two bonds identical in every way except for their coupons and, of course, their prices. Both have 12 years to maturity. The first bond has a 10 percent coupon rate and sells for $ The second has a 12 percent coupon rate. What do you think if would sell for?

Bond Price Reporting 10

Bond Price Reporting (cont.) 11 ATT6s00 : This tell us that the bond was issued by ATT, and it will mature in year The 6 is the bond’s coupon rate and the small “ s “ doesn’t mean anything important. Close : This gives us the last available price on the bond at close of business the day before. This bond last sold for 92 1 / 8 percent of $1,000 or $ Net Chg : This indicates that yesterday’s closing price was 3 / 8 of 1 percent lower than the previous day’s closing price. Cur Yld : The bond’s current yield is given in the first column. The current yield is equal to the coupon payment divided by the bond’s closing price : $60/$ = 6.51% Vol : The number of bonds that were bought and sold. For this particular issue, 89 bonds changed hands during the day.

Bond Features 12 The Indenture is the written agreement between the corporation (the borrower) and its creditors. Usually, a trustee (a bank, perhaps) is appointed by the corporation to represent the bondholders. Bonds frequently represent unsecured obligations of the company. A Debenture is an unsecured bond, where no specific pledge of property is made. The term Note is generally used for such instruments if the maturity of the unsecured bond is less than 10 or so years when it is originally issued. In general terms, Seniority indicates preference in position over other lenders, and debts are sometimes labeled as Senior or Junior to indicate seniority.

Bond Features (cont.) 13 Bonds can be repaid at maturity, at which time the bondholder will receive the stated or face value of the bond, or they may be repaid in part or in entirety before maturity. Early repayment in some form is more typical and is often handled through a Sinking Fund. A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds. A Call Provision allows the company to repurchase or “call” part or all of the bond issue at stated prices over a specific period. Corporate bonds are usually callable. Generally, the call price is above the bond’s stated value. The difference between the call price and the stated value is the Call Premium. Call provisions are not usually operative during the first part of a bond’s life. This makes the call provision less of a worry for bondholders in the bond’s early years. For example, a company might be prohibited from calling its bonds for the first 10 years. This is a Deferred Call. During this period, the bond is said to be Call Protected.

Bond Ratings 14 Low Quality, speculative, Investment-Quality Bond Ratings and/or “Junk” High Grade Medium Grade Low Grade Very Low Grade Standard & Poor’s AAA AA A BBB BB B CCCCC C D Moody’s Aaa Aa A Baa Ba B CaaCa C C Moody’s S&P AaaAAA Debt rated Aaa and AAA has the highest rating. Capacity to pay interest and principal is extremely strong. AaAA Debt rated Aa and AA has a very strong capacity to pay interest and repay principal. Together with the highest rating, this group comprises the high-grade bond class. A A Debt rated A has a strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse effects of changes circumstances and economic conditions than debt in high rated categories.

15 Bond Ratings (cont.) BaaBBBDebt rated Baa and BBB is regarded as having an adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this category than in higher rated categories. These bonds are medium-grade obligations. Ba, BBB, BDebt rated in these categories is regarded, on balance, as Ca, C CC, C predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. BB and Ba indicate the lowest degree of speculation, and CC and Ca the highest degree of speculation. Although such debt will likely have some quality and protective characteristics, these are out-weighed by large uncertainties or major risk exposures to adverse conditions. Some issues may be in default. DDDebt rated D is in default, and payment of interest and/or repayment of principal is in arrears

Types of Bonds 16 Treasury Bonds : Sometimes referred to as government bonds, are issued by the federal government. It is reasonable to assume that the federal government will make good on its promised payments, so these bonds have no default risk. Corporate Bonds are issued by corporations. Unlike Treasury bonds, corporate bonds are exposed to default risk—if the issuing company gets into trouble, it may be unable to make the promised interest and principal payment.

Types of Bonds 17 Municipal Bonds, or “Munis,” are issued by state and local governments. Like corporate bonds, munis have default risk. However, munis offer one major advantage over all other bonds: The interest earned on most municipal bonds is exempt from federal taxes and also from state taxes if the holder is a resident of the issuing state. Floating-Rate Bonds : The value of a floating- rate bond depends on exactly how the coupon payment adjustments are defined. In most cases, the coupon adjusts with a lag to some base rate.

Types of Bonds (cont.) 18 Zero Coupon Bonds : A bond that pays no coupons at all must be offered at a price that is much lower than its stated value. Such bonds are called zero coupon bonds, or just zeroes. Convertible Bond : It can be swapped for a fixed number of shares of stock anytime before maturity at the holder’s option. The number of convertibles have been decreasing in recent years. Foreign Bonds are issued by foreign governments or foreign corporations. Foreign corporate bonds are exposed to default risk, and so are some foreign government bonds. An additional risk exists if the bonds are denominated in a currency other than that of the investor’s home currency.

More on Bond Features 19 Features of a Hypothetical Bond TermsExplanations Amount of issue$100 millionThe company will issue $100 million of bonds. Date of issue10/21/95The bonds will be sold on 10/21/95. Maturity10/21/25The principal will be paid in 30 years. Face value$1000The denomination of the bonds is $1000. Annual coupon10.50Each bondholder will receive $105 per bond per year (10.50 % of face value). Offer price100The offer price will be 100% of the $1000 face value per bond. Yield to maturity10.50%If the bond is held to maturity, bondholders will receive a stated annual rate of return equal to 10.50%.

More on Bond Features (cont.) 20 Coupon payment dates7/1, 1/1 Coupons of $105/2 = $52.50 will be paid on these dates. SecurityNoneThe bonds are debentures. Sinking fundAnnualThe firm will make annual payments toward the sinking fund. Call provisionNote callable The bonds have a deferred call feature. before 12/31/05 Call price$1100After 12/31/05, the company can buy back the bonds for $1100 per bond. RatingMoody's AaaThis is Moody's highest rating. The bonds have the lowest probability of default.

End of Chapter 3 21